Musharaka. Shari’ah compliant or Shari’ah-based?

There has been much discussion over the principles of the Islamic finance industry. Adil Hussain looks at the increasingly important role of Musharaka

Increasing debate is taking place within the Islamic finance industry regarding the nature and characteristics of financial instruments which seek to comply with the principles of Shari’ah.

This debate has resulted in mainstream Islamic finance products being classified by some as either Shari’ah compliant or Shari’ah-based. Shari’ah compliant products are said to be those products which mimic their conventional counterparts by making necessary cosmetic changes to satisfy Shari’ah sensitivities. Shari’ah-based products, on the other hand, are said to be those which seek to observe the real spirit of Shari’ah and are observant of Shari’ah principles in substance.

There is almost unanimous consensus amongst Shari’ah scholars and other players in the Islamic finance industry that Musharaka is the purest form of Islamic financing. Islamic finance products structured according to Musharaka principles should therefore, in theory at least, fall into the Shari’ah-based category described above.

However, a number of transactions that have been structured using recently developed Musharaka financing techniques have been categorised by some as being Shari’ah compliant and it has been argued that only products based on classical principles of Musharaka are Shari’ah-based. To determine the correctness of these categorisations, one must have a general understanding of the concepts of Musharaka, and in particular the categories of Shirkat al Aqd (contractual partnership), Shirkat al Milk (co-ownership) and Musharaka Mutanakisa (diminishing Musharaka).

The word ‘Musharaka’ is derived from the Arabic word shirka, which means ‘sharing’. In the context of Shari’ah compliant financing, Shrikat al Aqd means the creation of a joint venture partnership in which all the partners share the profit or loss generated by that joint venture. Shirkat al Milk can be translated to mean the joint ownership by two or more persons of a particular asset or assets.

Shirkat al Aqd

• The majority of classical Islamic finance texts focus almost exclusively on principles that relate to Shirkat al Aqd. The main principles of Shirkat al Aqd are as follows:

• The proportion of profit to be distributed between the partners must be agreed upon prior to the consummation of the Musharaka;

• The Shari’ah does not permit any of the partners to be guaranteed a pre-determined fixed return;

• There is a difference of opinion among classical Shari’ah scholars as to whether the ratio of profit for each partner should be proportionate to each partner’s investment. The majority of contemporary scholars, however, permit the ratio of profit to differ from the proportion of investment made by each of the partners; and

• There is unanimous consensus among both classical and contemporary Shari’ah scholars that loss must be shared proportionately to each partner’s investment.

The application of Shirkat al Aqd is said to encapsulate the core principles of Islamic finance, namely the sharing of risk and profit and loss. By implementing a joint venture with its customer, the financier will directly participate in the risk of the business that it is seeking to finance. In simple terms, if the joint venture is successful both the financier and the customer will benefit, as the profits will be distributed between them according to the pre-agreed ratios.

If the joint venture is not successful, the financier and the customer will share the losses of the business in proportion to each of their respective investments. In any event, the customer will never be under an obligation to repay the capital investment made by the financier.

Shirkat al Aqd and Musharaka Mutanakisa

Whilst the principles of Shirkat al Milk are not new to Islamic finance, they have recently been used together with recently developed Musharaka Mutanakisa principles to create a new form of Musharaka financing. Recent Musharaka transactions based on Shirkat al Aqd and Musharaka Mutanakisa principles have been structured so that:

■ The financier contributes cash and the customer makes a contribution-in-kind to create a pool of assets, which are managed by an independent service contractor;

■ The customer grants a purchase undertaking to the financier under which it undertakes to purchase the financier’s share in the pool of assets on a deferred payment basis and at cost price;

■ Each time the customer makes a deferred payment to the financier, the financier’s interest in the pool of assets diminishes and the customer’s share in the asset increases;

■ Simultaneously with the above, the financier leases its beneficial share in the pool of assets to the customer; and

■ Title to the pool of assets is transferred to the customer once the financier receives full payment of its interest in the pool of assets.

Shari’ah based or Shari’ah compliant?

There can be no denying that Islamic financing products that are structured upon Shirkat al Aqd principles fall with the category of Shari’ah based. This is due to the fact that, in line with the fundamental principles of Islamic finance, the financier is exposed to a wider variety of risks than just the credit risk of the customer. In a transaction based on Shirkat al Aqd principles, the financier has no certainty of receiving a profit on its capital and has no certainty of having its capital repaid.

It is argued, however, that the same cannot be said for Islamic finance products based on Shirkat al Milk and Musharaka Mutanakisa principles and such products have therefore been categorised as being Shari’ah compliant rather than Shari’ah-based. Such arguments focus on the repayment obligations of the customer towards the financier through the purchase undertaking and leasing mechanisms.

The use of the purchase undertaking is said to violate traditional Musharaka principles, which are based on the concepts of risk and reward, as the financier is effectively guaranteed a return of its capital investment. Furthermore, the leasing arrangements are said to provide the financier with a pre-determined ‘profit’ return on its capital investment through the receipt of rental payments and this, it is said, contradicts traditional Musharaka concepts relating to profit sharing.

Musharaka is championed to be the most Shari’ah-based Islamic financing technique because it has traditionally been viewed purely as an equity instrument. The use of purchase undertakings and leasing techniques in Musharaka products based on Shirkat al Aqd and Musharaka Mutanakisa principles, however, are said to give such Musharaka products debt like characteristics, thereby merely making them Shari’ah compliant.

Ultimately, all those involved in the Islamic finance industry will have their own views as to what products they consider to be Shari’ah compliant and Shari’ah-based. It is, however, worth pointing out that while the principles of Shirkat al Aqd are the most commented upon in classical Islamic texts there is, in fact, no specific category of Musharaka that is preferred over another.

The principles of Shrikat al Milk and Musharaka Mutanakisa financing techniques are relatively new in the Islamic finance industry and they should not be rejected as being Shari’ah-based simply because there has been no precedent for their use in the past. This having been said, there must be a concerted effort to develop further and refine these principles so that they can become more Shari’ah-based. Indeed, some of the most prominent Islamic finance Shari’ah scholars, as guardians of the Islamic finance industry, have taken this task upon themselves by calling for a review of the use of purchase undertakings and leasing arrangements in Musharaka transactions.

Undeniably, everyone involved in the Islamic finance industry wishing to see the range of Shari’ah-based Musharaka products continue to expand will have to play a role in the further development and evolution of existing Musharaka concepts so that they can continue to be applied in the modern Islamic banking world.